COMMERCIAL BANKING

Chapter 3
Evolution & Origin of Commercial
Banking
 The word bank is used in the sense of a commercial
bank.
 The word bank has a German origin though some
people believe that it has come from a French word
‘Banqui’ and yet others believe that it has come from
the Italian word ‘Banca’. Whatever it is, it referred to
a bench for keeping , lending and exchanging of
money or coins in the market place by money lenders
and money changers.
 There was no such word as banking before 1640,
although the practice of safe keeping and savings
flourished in the temples of Babylon as early as 2000
BC.
 In India also reference of banking system could be
found in the ancient Jain Temples and literary works
like that of Chanakya etc.
 The first bank called the ‘Bank of Venice’ was established in Venice,
Italy in 1157 to finance the monarch in this wars.
 The bankers of Lombardy were famous in England, but modern
banking began with the English Goldsmiths only after 1640.
 The First Bank in India was Bank of Hindustan started in 1770 by
Alexender and Co.
 But the first bank in modern sense was established in the Bengal
Presidency as the Bank of Bengal in 1806.

 It was merchant bankers who first evolved the system of banking by

trading in commodities than in money. Their trading activities required
the remittance of money from one place to another. For this they
issued ‘hundis’ to remit funds. In India such merchants were known as
‘SETHS’
 The next stage in the growth of banking was the ‘goldsmith’ His
business was such that he had to take special precaution against theft
of gold and jewelry and if he seemed to be an honest person
merchants and neighbours started leaving their bullion, money and
ornaments in his care. As this practice spread the goldsmiths started
charging something. As an evidence for receiving valuables he issued a
receipt – these acted like cheques and were used as a medium of
exchange. The GSm also lending money (Coins of G& Silver) as not all
of them were demanded back at the same time.
Meaning of Bank
A Bank is an institution which accepts deposits
from the public and in turn advances loans by
creating credit. It is different from other financial
institutions in that they cannot create credit
though they may be accepting deposits and
making advances.
 Commercial Banks: Are those banks which
perform all kinds of banking functions such as
accepting deposits, advancing loans, credit
creation and agency functions. They are also
called joint stock banks because they are
organised in the same manner as JSCs.
Role of Commercial Banks in a
Developing Country
Mobilizing Saving for Capital Formation
Financing Industry
Financing Trade
Financing Agriculture
Financing Consumer Activities
Financing Employment Generating
Activities.
Help in monetary Policy
 Two
Essential
Functions
Functions of Commercial Banks Borrowing &
Lending
AcceptingDeposits (Savings, Current and Fixed Dep.)
Advancing Loans (1.Cash Credit – bank advances loans
to businessmen against certain specified securities. The amount
of loan is credited to the current account of the borrower, and the
borrower can withdraw money through cheques., 2.Call loans –
These are very short term loans advanced to the bill brokers for
not more than 15 days. They are advanced against first class bill
or securities. Such loans can be recalled in very short notice.
3.Overdraft – A bank often permits a business man to draw
cheques for a sum greater than the balance lying in his current
account. 4. Discounting BOE – If a creditor holding a BOE wants
money immediately, the bank provides him the money by
discounting the BOE…)
Credit Creation ( Credit creation is one of the most
important functions of commercial banks. Like other business
organisations they also aim at earning profit, for this they accepts
deposits and advance loans by keeping a small cash in reserve for
day to day transactions. When a bank advances a loan, it opens
an account in the name of the customer and does not pay him in
cash but allows him to draw the money by cheque according to
his needs. Thus by granting a loan the bank creates credit of
deposit.)
Financing Foreign Trade : ( Accepting foreign bills
of payment etc.)
Agency Services
Miscellaneous Services
Commercial Banking
in India
Management of Commercial Banks
in India
TOPICS For
 Commercial banking in India an overview Discussion
 Opportunities and Challenges
 Management in Commercial banks
 Liquidity management in Commercial banks
 Management of Deposits
 Management of Primary & Secondary Reserves
 Management of Loans (Priority sector Lending and Working
Capital Financing)
 ALM
 Management of NPA
 Management of Income in Commercial Banks
 Profitability and Productivity in Commercial Banks
 Performance Evaluation of Commercial Banks
 Commercial banking in India
In over 5 decades since independence
banking system in India has passed
through certain distinct phases:
◦ Evolutionary Phase (prior to 1950)
◦ Foundation Phase (50s to 70s)
◦ Expansion Phase ( 70s to Mid 80s)
◦ Consolidation Phase ( Mid 80 – to 90s)
◦ Reformatory Phase ( Since Liberalisation)
Evolution Phase
 Enactment of the RBI Act in 1935 gave birth to a new category of
banks called Scheduled Banks in India but some of these banks
were already been in existence since 1881.
 Prominent Scheduled banks were: Allahabad bank 1865 , Oudh
Comercial bank 1881, Ajodhya Bank 1884, PNB 1894,
Nedungaddi bank 1899
 During 1901-1914 12 more banks were established, prominent
among them were BOB 1906, Canara Bank 1906, Indian Bank in
1907, BOI in 1908, Central Bank of India 1911
 During the war period not much of a development took place,
there was a heavy rush on banks and the banks faced serious
crisis… many succumbed to the pressure and perished.
 But after the wars and the independence as many as 20
scheduled banks came into existence. UBI was formed in 1950 by
the merger of 4 existing commercial banks,
 In a span of 5-7 years the figure rose to 81 but by 1968 23 were
either liquidated or amalgamated into new banks leaving 58
scheduled banks in operation.
Foundation Phase
 The focus was on class banking and security
rather than on purpose.
 The emphasis of the banking system during this
period was on laying the foundation for a sound
banking system in the country
 Consequently the phase witnessed the
development of necessary legislative framework
and as a result the BANKING REGULATION ACT
was passed in 1949 to conduct and control
operations of the commercial banks in India.
 During the period number of Commercial banks
declined remarkably.. From 566 banks in 1951 to
281 in 1961.
 The major factor for this change was the
consolidation and strengthening of the banking
structure and the organisation drive started by
the RBI after the enactment of BRAct 1949, with
a view to improving the quality of banking
services and widening the geographical and
functional spread of their activity.
Expansion Phase
 This phase witnessed socialisation of banking in 1968.
Commercial banks were viewed as agents of change and
social control on banks
 Since inadequacy was felt in this front, 14 banks were
nationalised in 1969 and another 6 in 1980.
 This period also witnessed the birth of RRBs in 1975 and
NABARD in 1982 which had priority sector as their focus of
activity.
 Although number of commercial banks declined from 281
in 1968 to 268 in 1984, no. of scheduled banks shot up
from 71 to 264.
 As many as 50,000 bank branches were set up of which
3/4th were in rural and semi urban areas.
 In fact so rapid was the growth in these areas that the
banking industry had hardly any time to consider other
issues and consequently with growth came inefficiency and
loss of control. As a result profitability came under strain.
 Backdrop: In the early decades the banking system in India came to suffer from the following
weaknesses:
◦ The banking system was localised in a few metropolitan and urban cities, neglecting the vast
and potential rural areas as unbanked
◦ The banking system remained confined to industry and trade, ignoring the vital interests of the
priority and neglected sectors, including agriculture and small scale industries and artisans.
◦ Enormous concentration of economic power existed in the banking sector. A few business
houses were in effective control of powerful banks. Thus commercial banks contributed to the
enormous growth of big business houses, leading to emergence of industrial monopolies.
◦ In view of the above weaknesses it was necessary to align bank credit flows into broader areas.

◦ Priority Sector Lending became the principle focus.

◦ The other focus was to make the banks vibrant and potent instrument of development and
making them a mass institution.
◦ Thus the scheme of social control was introduced in 1968 with the main objectives of achieving
a wider spread of bank credit, rectifying sectoral and regional imbalances, and directing credit
flows to priority sector.

 Objectives of Nationalisation of Banks

◦ To control the commerical heights of the economy
◦ To extend banking facilities to unbanked and underbanked centres, specially in
rural areas
◦ To ensure an increased flow of assistance to the neglected sectors
◦ To foster the growth of new and progressive entrepreneurs
◦ To give a professional bent to bank management with a view to removing the
control of a few.
Consolidation Phase
 This was a phase of realisation and consolidation
of losses.
 The phase began in 1985 when a series of policy
initiatives were taken with the objectives of
consolidating the gains of branch expansion
undertaken by the banks and the relaxation of
the tight regulation.
 Although number of scheduled banks increased
from 264 in 1984 to 276 in 1980 branch
expansion of the banks slowed down. Hardly
7000 branches were set up during this period.
 For the first time serious attention was paid to
improving housekeeping, customer services,
credit management, staff productivity and
profitability.
 However, this phase had to witness the worst
days in the Agriculture and Rural debt portfolio.
 By this time 90% of the commercial banks were
in the public sector and closely regulated in all its
facets:
Like prices of assets and liabilities were regulated by RBI,
Prices of services were fixed uniformly by the IBA
Composition of assets were also somewhat fixed in as much
63.5% of the bank funds were mopped up by the CRR & the
SLR and the remaining was to be directed towards the
priority sector.
Salary structure was negotiated by the IBA
 Thus there was no autonomy in vital decisions,
and drive towards efficiency was almost non
existent.
Reformatory Phase
 Continued financial profligacy (decadence) of the
Government coupled with close monitoring and control
rendered the banking system on the verge of bankruptcy,
and thus drastic reforms were inevitable.
 In the same period, India, for the first time faced the
problem of defaulting on its international commitments and
the access to external commercial credit markets was
completely denied, International credit ratings had been
downgraded and the International financial communities'
confidence in India’s ability to manage its economy had
been severely eroded.
 Thus the Govt. had to initiate swift action to restore
international confidence.
 Various macro economic structural reformatory measures
were undertaken in the field of Foreign trade, tax system,
industrial policy and financial and other sectors…
 Banking Sector in India, has gone through a metamorphosis during the
last decade. While baking sector contributed to a great extent in creating
a vital infrastructure for national building, generating employment
opportunities and expanding business, it also, suffered a lot during the
course of expansion from deficiencies with regard to their efficiency and
quality of operations, controls, mechanism and profitability.

 Some extraneous factors which contributed towards this inefficiencies are:

◦ Over regulations led to weakening of the management functions
◦ Directing lending led to stunting of the innovative skills of the bankers
◦ Social control came to be synonymous with political control with loan
writing off completely eroding the basic character of banking business
◦ Trade unionism and muscle power lead to day to day interference in
individual credit decision making and internal management and poor
work culture.
◦ Customer Service was yet another area of concern
◦ Too much expansion and too fast a pace, resulted in an increase in the
establishment and overhead costs and coupled with underequipped
management profitability strained.
Recommendations of Narsimham
Committee – 1 Report
 Inthe light of the above mentioned shortcomings
and deterioration in the financial health of the
banking system, quick and comprehensive
remedial measures became an immediate
necessity. Accordingly the GOI constituted in
August 1991 a high powered committee under
the chairmanship of Shri.N.Narsimham, the then
Governor or RBI to examine all aspects relating
to the structure, organisation, function and
problems relating to the Banking System.
Major
Recommendations:
 Phased reduction in statutory preemptions
 Interest rates on CRR balances
 Phasing out of directed credit programme
 Interest rate deregulation
 Capital adequacy norms (should attain a CAR of 8% by 98)
 Income recognition
 Asset Classification
 Transparency
 Tax treatment of Provisions
 Loan recovery
 Tackling doubtful debts
 There should be no further nationalisation of banks
 Restructuring the banks
 Entry of Private Banks
 Branch Licensing
 Foreign Banks
 Supervision of Banks
 Control of Banking System

Action on the
Recommendations:
 Phasing of reduction of Reserve Requirements
◦ SLR: 25% on the basis of incremental NDTL wef. 30.9.94
◦ CRR reduced to 14% & then to 13% in Credit pol of April, 1996. 12%..
Then 10% finally to 8% by July 99
 Interest Rate on CRR Balances : (4%)
 Phasing out of directed credit programme:
 Interest rate deregulation: Banks were given the freedom to
have their own reference rate (PLR) instead of floor and ceiling rates, and
fix individual borrower’s int rate within a band of PLR.
 Capital Adequacy Norms: RBI introduced it as per the rec.
and as of 31st March 1997 only 2 banks (UCO and the Indian banks) were
not able to achieve the norm of 8%
 Asset Classification: wef 1.4.92 had to implement the guidelines
of RBI and classified their loan assets based on record of recovery and
also started recognising income based on this. Because of this many
banks in the period March 93-March 97 reported huge losses.
 Transparency: RBI came up with a different format of bank B/s
and P&L a/c as distinct from the one suggested by the committee, in
march 1992. During 96-97 more significant additions such as: break up of
capital adequacy ratio, provisions made for the year, NPA % etc were
introduced. In 1998 banks were directed to disclose 7 critical ratios
relating to productivity and profitability.
Capital Adequacy:
Minimum capital to risk-
weighted-asset ratio
 Tax Treatment of Provisions: The limit of admissible
deductions was enhanced to 5% of the income and 10% of av. Aggregate
advances of rural branches.
 Loan Recovery: As recommended the Govt, passed an Act in 1993
for the creation of recovery tribunals for loan accounts with outstanding
balances of Rs. 10 L or more, it also established 8 such tribunals and an
appellate tribunal in Mumbai which upto March 1998 covered 20 states
and 4 UT.
 Tackling of DD: No steps had yet been taken in regard to creation
of an Asset Reconstruction Fund, as recommended by the committee.
 Restructuring of the Banks: No progress in this respect was
made except that on 4.9.93 a loss making bank called New Bank of India
merged with PNB.
 Private Banks: BR(A)Act 1994 was passed to permit private sector
banks to enter the banking field. RBI gave licence to 9 pvt banks. By the
end of 1994.
Narsimham Committee II Rep
It was again reconstituted in the year
1997 to suggest measures to strengthen
the banking sector of the country.
The committee submitted a report on
April 1998
Main recommendations of the committee
are as follows:
Major Recommendations
 Merger of Strong PSBs & Recapitalisation scheme for weak banks
 Government should have a lesser role & greater autonomy should be
allowed
 Functions of boards and managements need to be reviewed
 Moving away from excessive concentration on asset mgt. to ALM with a
view to modifying their liability in consonance with their desired asset
structure.
 Thee is a need to review minimum prescription for Capital Adequacy. In
this regard the committee recommended that minimum CAR be raised to
10% by 2002. By now most of the banks have a CAR of 11% or higher.
 The committee also felt the need to lay down prudential and disclosure
norms and sound procedures for the purpose of supervision and
disclosure.
 There should be greater specialisation by banks in various niche areas like
Retail, agriculture, SSI, Industry etc.
 Banks should place greater reliance on non fund based business such as
advisory and consultancy services, guarantee and custody services
 There is a need for PSBs to speed up computerisation and focus on
relationship banking.
 Need for professionalising and depoliticising of bank boards
 Should have thrust on greater financial intermediation with large
companies. Accessing securities debt domestically and from financial
markets abroad. (There should be an integration of NBFCs lending
activities into the financial services)
 A review of recruitment procedures, training and remuneration policies in
PSBs should be carried out. BSRB should be abolished
 Should concentrate on mgt of credit risk and better mgt of NPAs.

Action on the Recommendations:

In conformity with the committees recommendations, the RBI
announced a package of measures in October 1998:
 Increase in the min CAR from 8 to 9% and 10% by March 02
 Recognising of market risk and thereby prescribing of a risk weight of
2.5% in Govt. approved securities by March 2000
 The Govt. started contemplating a reduction in its share holdings in PSBs
from 51% to 33%
 100% risk wt for foreign exchange
 Moving towards tighter asset classification, income recognition and
provisioning norms. (Asset to be classified as doubtful if it remained in
substandard category for more than 18 mts instead of 24 mts wef. 31st
March 2001)
 Banks have now to classify a minimum 75% of their investments
in approved securities has current investments. This has been
done with a view to adopt prudent accounting standards.
 Also banks and FIs investment I Tier II bonds issued by other
banks or financial institutions will be subjected to a ceiling of
10% of the bank’s/ FIs total capital (this was done to avoid cross
holdings)
(On ring
Verma Committee s t r uctu nks)
Re k ba
Report: of w
e a

The NC-II rep. defined a weak bank as one whose accumulated losses and
NPA exceeds its net worth and whose adjusted operating profits (op
profits – income on recapitalisation bonds) was negative for three
consecutive years.

Based on this the Verma Committee on Restructuring of Weak Banks set up

by the RBI in Feb, 99 identified 3 banks as weak banks. (UCO, UBI and
Indian Bank)
 The Committee, for this purpose identified 7 parameters
covering 3 areas for classifying a bank as weak. These are:

◦ Solvency ( CAR & Coverage Ratio)

◦ Earning Capacity ( ROA and Net Int Margin)
◦ Profitability (Ratio of operating profit to average working funds, ratio of
cost to income and ratio of staff cost to net interest income plus all
other income)

 Major problem that still haunts the industry is the growing

proportion of NPA reaching astronomical figures of about
1Lakh Crore.
 NPA consists of assets under three categories:
◦ Sub-standard (is one which remains an NPA for ≤ 12 months)
◦ Doubtful assets (are those which remain NPA for >12 months)
◦ Loss assets (are those, which have been identified as loss by the bank
or internal/external auditors or by the RBI inspection but the amount
has not been written off)
Based on the recommendations of both the NC-II & the
Verma Committee the following measures have been taken
to address the problems of the Banking Industry:

 More and more debt recovery tribunals and appellate tribunals

were to be set up, and empowered them to facilitate expeditiious
adjudication and recovery of banks and FIs dues. Accordingly,
comprehensive amendments have been carried out in the
recovery of debts due to Banks and FIs Act, 1993 by issue of an
ordinance. (As many as 29DRTs & 5 ATs have been set up so far)
 A credit information bureau has been set up to curb the growth of
fresh NPAs
 Changes in legislative provisions have been made to accord
necessary flexibility and autonomy to the boards of banks to
enable them to take decisions on corporate strategy and be
responsible to the share holders, customers, employees and the
public at large.
 In order to reduce the staff cost of PSBs Govt. has introduced
the VRS scheme
 Transparent guidelines have been formulated for banks
investment in shares and financing of equities
 BSRB has been abolished and banks have accordingly been
advised to frame their own recruitment strategies.
 The Deposit Insurance Credit and Guarantee Corporation
has been converted into the Bank Deposit Insurance
Corporation to make it an effective instrument for dealing
with depositors risk and for dealing with distressed banks.
 Banks have set up separate recovery departments and
their legal cells are being strengthened.